Brexit creates ‘huge question mark’ over unhedged funds

Attention turns to sterling-hedged share classes on potential sterling rally

Sterling weakness since the Brexit referendum has acted as a boon for investors with exposure to global assets, but a potential uptick in the pound if the UK’s future becomes clearer could threaten portfolio gains if they are not currency hedged.

The six-month Brexit extension has prolonged economic uncertainty and sterling is likely to stay beaten down, but some investors are looking to increase currency hedging on the belief that the pound could strengthen – and sterling-hedged share classes are moving onto their radar.

Currency hedging is no precise art but in general terms in a hedged sterling share class a strong sterling versus the currency of the fund’s investment strategy will increase returns, whereas a weak sterling will mean worse performance. For UK investors in an unhedged sterling share class, the opposite is true.

Sarasin & Partners founding partner Guy Monson (pictured) believes there could be a “strong and possibly multi-year rally” in sterling if a deal is inked between the UK and Europe, whatever that looks like, which presents a huge question mark for UK fund buyers who have ridden the wave created by a depressed currency.

He says: “The high adoption of global funds has been good because, in general, international markets work for domestic markets, but it’s been particularly good because it’s been a tremendous hedge against Brexit, and most clients, although they don’t know it, are sitting on huge FX gains in their ISAs or their pensions.

“What happens if that goes into reverse and suddenly from being problem nation number one, we suddenly come, dare I say it, almost a safe haven? I think one of the issues for the fund management industry is can we provide investors with sterling-hedged solutions?”

Hedged global strategies hard to find 

But sterling-hedged share classes of funds are not that easy to find. They tend to be more popular for single country exposure such as Europe and the US, and particularly Japan, but there are few hedged global equity strategies largely because there are a variety of currencies to hedge in a global fund.

“You probably look down a lot of shares and you see sterling share class,” Monson says. “That often just means the price is in sterling, but the assets are all international, so there are relatively few fully hedged products.”

But hedged global equities have performed poorly over the past 12 years. Unhedged equities (MXWO Index) have outperformed their currency hedged (WHANWIHG Index) equivalents by 107% over the period. Similarly, over a five-year period, taking the Brexit vote into account, unhedged equities have outperformed their hedged counterparts by 40% (see charts).

Hedged global equities versus unhedged over past 12 years

Hedged global equities versus unhedged over past 5 years

Source: Bloomberg

“Over the past 10 years-plus the difference in performance between hedged and unhedged global equities has been massive,” says Psigma Investment Management head of investment strategy Rory McPherson. “Clearly Brexit fears have hurt sterling, but it had been getting steadily weaker over the longer period too.”

As a rule, Psigma hedges currency for fixed income but not equities. Regarding the latter, it has a home bias (20-25% in UK equities) and the remainder in unhedged global stocks, which boils down to roughly 50/50 exposure to local currency and overseas.

However, McPherson says currency hedging for equities is now worth exploring because if the UK has a soft Brexit or no Brexit sterling would strengthen quite considerably. “If you are prepared to take a long view on it, it looks like a really cracking opportunity,” he adds.

Where to hedge

Japan is a good example of where Psigma would hedge its equity exposure because it is an export-led economy and the market does well if the yen is weak. Hedging enables those gains to be pocketed and not be wiped out by a weak yen, McPherson says.

Shore Financial Planning director Ben Yearsley says the firm considered currency hedging back in January but essentially decided not to go ahead because for adviser firms it is more complicated and time consuming to switch to currency-hedged share classes. Discretionary fund managers on the other hand are better equipped to switch, he adds.

He also says there are only really three currencies to hedge: yen, dollar and euro. Like McPherson, Yearsley sees Japan as an area where currency hedging is necessary and he hedged half of his Japan holdings a few years ago because it was obvious the yen was going to move sharply. He has left this position untouched.

“I have left it because the market is still cheap, so by hedging out the currency I’m benefitting from that and also from sterling weakness. Am I comfortable with that position? I probably am because some of it is unhedged and there is no guarantee sterling is going to do anything,” he says.

Yearsley says the only other market worth hedging is the US because the stock market’s earnings are not as international as Europe where the split between domestic and global earners is about 50/50 and often multi-national companies will hedge currencies themselves.

“You have companies’ revenues coming from outside of Europe and therefore if you are trying to hedge the currency, which currency are you hedging? Are you undoing companies’ hedge? It works better in the US and Japan.”

Felix Wintle, manager of the VT Tyndall North America fund, says the firm launched hedged share classes due to client request. The fund was launched after the referendum in July 2017 and Wintle says some clients felt that sterling had been sold off so much that a hedged option was desirable.

“I think they appreciate being given the option of controlling their currency exposure, particularly now when things are at such an extreme,” he says.

Cost of hedging funds

As well as complexity, investors are often put off hedging by the cost which is based on interest rate differentials. With UK base rates at 0.75%, hedging back from countries with higher rates, such as the US where it is 2.5%, means selling out of a higher  rate and investing at the lower one.

“When you throw into the mix bond yields being super low it doesn’t lend itself to having US bonds,” says McPherson. “You might look at a US treasury bond and say it has a 2.6% yield versus a UK gilt 1.2% yield, but it is not when you take off the 1.8%; you are left with 0.8%.

Coutts senior multi-asset fund manager Jeremy Ward says cost is a factor, but it hasn’t been too penal over the last few years when all major central banks had interest rates at zero or near zero.

“But now the Fed is at 2.5% the hedging costs have increased as it’s based on interest rate differentials.”

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